S&P 500: Are Return Expectations for 2025 Too High?
2025.01.22 07:35
In a , I discussed Wall Street’s return estimates for 2025 for the . To wit:
“We have some early indications of Wall Street targets for the S&P 500 index, and, as is always the case, they are optimistic for the coming year. The median estimate is for the market to rise to 6600 next year, which would be a disappointing return of just 8.2% after two years of 20% plus gains. However, the high estimate from Wells Fargo suggests a 14% return, with the low estimate from UBS of just a 5% return. Notably, there is not one estimate available for a negative return.”
However, it isn’t just Wall Street analysts who are optimistic about 2025 returns. Retail investors are the most optimistic about higher stock prices in 2025 by the most on record.
Unsurprisingly, that sentiment resulted in the psychological rush to overpay for assets, pushing forward 1-year valuations sharply higher.
Note that I stated that optimism about returns in 2025 is primarily a function of psychology. Over the last 15 years, stock market returns have run well above the long-term average of roughly 8%. Over the long run, which is the last 125 years, stocks have returned roughly 6% from capital appreciation and 4% from dividends on a nominal basis. However, since inflation has averaged approximately 2.5% over the same period, real returns are roughly 7.5% annually.
The chart below shows the average annual inflation-adjusted total returns (dividends included) since 1948. I used total return data from Aswath Damodaran, NYU Stern School of Business. The chart shows that from 1948 to 2024, the market returned 9.26% after inflation. However, after the 2008 financial crisis, inflation-adjusted total returns jumped by nearly three percentage points for the last three observation periods.
Here is the issue. Total real (inflation-adjusted) stock market returns are easy to calculate. They are a function of economic growth (GDP) plus dividends less inflation. Such was the case from 1948 to 2000. However, since 2008, growth has averaged roughly 5% with a dividend yield of 2%, yet returns have far surpassed what the economy can generate in earnings.
Those consistently higher returns over the last 15 years have trained investors to expect elevated portfolio returns from the financial markets.
But is that realistic?
A Decade And A Half Of Outsized Returns
As we head into 2025, we must review what drove those outsized returns over the past 15 years and review what conditions exist today to support elevated returns in the future.
As noted, over the long term, there is an obvious relationship between the stock market and the economy. This is because economic activity creates corporate revenues and earnings. As such, stocks can not indefinitely grow faster than the economy over long periods. When stocks deviate from the underlying economy, the eventual resolution is lower stock prices.
For example, the chart below compares the three from 1947 through 2024. The surge in earnings in 2021 resulted from reopening the shuttered economy in 2020, but that reversed in 2022 and returned to normal growth rates in 2023-2024 along with economic growth. However, as shown above, asset price returns are well above normal despite slower earnings and declining economic growth rates.
Since 1947, earnings per share have grown at 7.72%, while the economy has expanded by 6.4% annually. That close relationship in growth rates is logical, given the significant role that consumer spending has in the GDP equation.
As we saw in 2021, the difference between earnings and GDP growth is due to periods when earnings can grow faster than the economy. This is the case when the economy is coming out of a recession. However, while nominal stock prices have averaged 9.36%, reversions to underlying economic growth eventually occur. This is because corporate earnings are a function of consumptive spending, corporate investments, imports, and exports.
So, if the economic and earnings relationship is true, what explains the market disconnect from underlying economic activity over the last 15 years? In other words, what drove portfolio returns, if all else is equal? Two differences in the previous 15 years didn’t exist before 2008.
The first is corporate stock buybacks. While corporate share repurchases are not new, the egregious use of buybacks to boost earnings per share accelerated post-2008. :
“In a previous Wall Street Journal study, 93% of the respondents point to “influence on stock price” and “outside pressure” as reasons for manipulating earnings figures. Such is why stock buybacks have continued to rise in recent years. Following the “pandemic shutdown,” they skyrocketed.”
The second is monetary and fiscal interventions, unprecedented since the financial crisis.
As ” the psychological change is a function of more than a decade of fiscal and monetary interventions that have separated the financial markets from economic fundamentals. Since 2007, the and the Government have continuously injected roughly $40 Trillion in liquidity into the financial system and the economy to support growth.
That support entered the financial system, lifting asset prices and boosting consumer confidence to support economic growth.
However, over the last two years, while the Federal Reserve reduced its balance sheet and lifted rates, stocks climbed higher on expectations the Fed would eventually reverse course.
At the same time, federal expenditures have continued to swell, offsetting the reduction in the Fed’s balance sheet and higher borrowing costs.
The high correlation between these interventions and the financial markets is evident. The only outlier was during the Financial Crisis when the Fed launched the first round of Quantitative Easing (Q.E.). What followed was multiple Government bailouts, support for the housing and financial markets, zero interest rates, and eventually direct checks to households in 2020.
Given the repeated history of financial interventions over the last 15 years, it is unsurprising that investors now expect elevated portfolio returns in the future.
However, there are headwinds to those assumptions as we head into 2025.
Headwinds In 2025
Since the election, optimism has increased that the Trump administration will pass policies that will boost economic activity, reduce regulations, and cut tax rates.
That surge in optimism was evident in the most recent National Federation of Independent Business () survey.
However, there are risks to those more optimistic assumptions for strong economic growth and continued strong portfolio returns. As noted, we must assume several factors for the market to deliver above-average returns.
- Economic growth remains more robust than the average 20-year growth rate.
- Wage and labor growth must reverse (weaken) to sustain historically elevated profit margins.
- Both interest rates and inflation need to decline to support consumer spending.
- Trump’s planned tariffs will increase costs on some products and may not be fully offset by replacement and substitution.
- The planned reductions in Government spending, debt issuance, and the deficit do not occur, supporting corporate profitability ().
- Slower economic growth in China, Europe, and Japan must reverse to support demand for U.S. exports.
- The Federal Reserve continues to cut rates and slows or stops the reduction of its balance sheet to support market liquidity.
However, the current data trends do not support those assumptions. This is particularly true when current valuations deviate from the long-term exponential growth trend. Earnings must grow rapidly to justify the excess valuations. However, if those earnings fail to meet elevated expectations, the eventual reversal of market prices to realign valuations with earnings realities can be somewhat brutal.
As Jeremy Grantham noted:
“All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.
Today in the U.S. we are in the fourth superbubble of the last hundred years.”
Whether you agree or not that we are developing another market bubble is a choice. However, the deviation from long-term growth trends is unsustainable. Repeated financial interventions by the Federal Reserve and the government have caused the current deviation to be well above anything seen in previous history.
Therefore, reversing returns to their long-term means seems inevitable unless the Federal Reserve is committed to a never-ending program of zero interest rates and quantitative easing.
Given the current market dynamics, it is hard to fathom how forward return rates will not be disappointing compared to the last decade. However, the excess returns investors have become accustomed to were the result of a monetary illusion. The consequence of dispelling that illusion will be challenging for investors.
Will this mean investors make NO money in 2025 or beyond? No. It only means that returns will likely be substantially lower than investors have witnessed recently. But then again, getting an average return in 2025 may be “feel” very disappointing to many.
